Clear Eyed Capitalist

Archive for November, 2006

I hearken once again to the ole statement by Milton Freedman that says “The business of business is business”. He published that in 1970, the year I was born, and that phrase has since been interpreted to mean the business of business is profit. The result has been a society that’s increasingly focused on concentrating and extracting value. But the truth is, the business of business is community – the community of customers, employees and suppliers that come together to keep it going.

Bryan Smith and Art Kleiner make an excellent point about this in the 5th Discipline Fieldbook in the section on shared vision and purpose. They make the point that if the purpose of a company is merely to maximize return on investment to shareholders, then all companies have the same purpose – making this purpose the primary one distracts from the company’s true competitive advantage. Profit is a necessary but not sufficient condition for a business to thrive – it needs to have a larger purpose that keeps stakeholders attached.

Charles Handy also covers this in his article “What’s a Business For?”, published in the Harvard Business Review collection on Corporate Responsibility. He points out that in the lifetime of capitalism the purpose of business has shifted – instead of true owners we now have investors, which despite relatively little involvement in the company still have the entitlements of ownership. Our accounting treats the business as property and the employees as costs, leaving them unrepresented in the decisions that most closely affect their quality of life.

So how has business come to exploit community more often than support it? I identify two reasons: economies of leverage and competitive investing.

The term “economies of scale” is a common one, and I realize that as a small investor I’ve had a misperception of what that actually means. I somehow assumed that it was a business parallel for my own household – buy larger quantity and get a better price from suppliers. You get a better price because fixed costs are a smaller percentage of the total – packaging, transportation, Selling & Administrative. Like how when we buy from the warehouse store things are cheaper than the grocery store, which is cheaper again than the convenience store. Margins improve, and also with scale you’re just making more money.

As I learn more about business I realize that’s a distraction. The truth is that having scale is much more about having leverage in your negotiations. Your margins get better not just because the ratio of fixed to variable costs but because of your size relative to suppliers which gives you more negotiating power to transfer costs of your transaction to them, costs like transportation, special packaging, display materials. On non-perishables you might negotiate the right to return unsold product to your suppliers if you’re a retailer, or charge them “slotting fees”, a price for the right to even show up in your store. “Economies of Scale” is now supplanted by the more important “Economies of Leverage”.

In an Economy of Leverage, growing a business becomes a choice – remain a niche player or jump to scale. You have to jump because you’re aiming for a business model that can only be profitable at scale when your negotiating leverage kicks in and you’re no longer being kicked around. The growth period is merely capital burn, something a founder needs to minimize if they want to retain any ownership. That capital growth period is a gauntlet of its own, each stage a series of investors looking to test how desperate the company is for capital by how much they can press the founder and prior investors to give away their ownership in return for fresh cash. Wait too long and management and early investors will find themselves “crammed down” under threat of having the not-yet-profitable company fail.

The investment community (sometimes represented by investors, sometimes managers, sometimes analysts) suffers from not having a standard of “good enough”. We know what inflation is. We can make estimates of what someone needs to “retire” at a given age. Those numbers rarely come into play when evaluating whether or not a given investment return is satisfactory. They can’t, they’re too individual is what we say. But the truth is, when one fund manager is competing against another in rankings, or when one angel investor is trying to outshine the next, or VC firms are competing for bragging rights, there’s no such thing as “enough”, there’s only “more” and “most”. There’s a bit of bad blood between angels and VCs, in fact, because in the dot-com boom more than a few deals VCs negotiated a few extra points of return by taking it out of the angels and company founders that preceded them. Companies are taking it out of their employees when they’re cutting benefits and dumping pension plans. It’s about competing and trying to out-do each other. It’s a system where what happens to capital is more important than what happens to people, even though it’s premised on capital existing for the benefit of people.

If we want to live differently, we’re going to need to figure out how to help companies grow differently. Then they can hew to their primary mission of being a community that successfully connects supply to demand and thrives as it does so, instead of constantly seeking new ways to manipulate their goal in service of short-term profit.